In the wake of the last real estate crisis in the United States, the Savings and Loan Crisis, house prices also declined (along with commercial real estate) and the economy was a major topic of the 1992 Presidential campaign between Bill Clinton and George H.W. Bush. Clinton’s campaign director, James Carville coined the phrase “It’s the economy stupid” to highlight that President Bush was too focused on international affairs and not focused enough on the US economy. To quote one my favorite Yogi Berra malapropisms, “its déjà vu all over again”. Only this time we can put an even finer point on it, it’s the housing market stupid!

That the housing market, the nexus of US Economic dislocation, is still quite hobbled is not lost on Washington. In January the Federal Reserve put out a white paper on the housing market which advocated a multipronged approach to clearing bad debts off the books of the GSEs and the banks. In the President’s State of the Union address he outlined several new measures to help homeowners. On February 9th, the State Attorney Generals for 49 states (only Oklahoma’s Attorney General did not participate) settled that the five largest mortgage servicers would pay $26bn to make up the difference between the mortgage value and the value of “underwater” homes. Naturally what happens in housing is linked to the health of the overall economy as housing wealth is a key driver of the consumption function. But the health of the housing market also impacts other areas such as growth in construction jobs, the auto sector (think pickup trucks), building materials and of course municipal finance and spending. It is an important economic issue for the Fed and an important political issue for the President, especially in an election year. For bond investors it is important because what happens in the housing sector will have a disproportionate impact on inflation, rates and credit. Naturally the housing market is itself linked to what happens with employment and the Fed remains focused on getting employment up as well, but the two are intertwined. However, at the moment the refinance market is the main policy factor the Fed has to impact consumer spending and increase the velocity of money.

In order to really “fix” housing, that is to write down the approximately $700bn by which borrowers are underwater on their first lien mortgages and the nearly $400bn they are underwater on (Home Equity Lines of Credit) HELOCs, at least one of the stake holders will have to take a haircut and there are really only three options: banks take the write-down (via foreclosure or debt forgiveness), tax payers pay by allowing Fannie or Freddie to take the write down, or we continue with forbearance hoping that the housing market comes back to life spurred on by the various measures that have been taken/proposed so far. In and of itself, writing down debt is deflationary and it is the Fed’s belief that it is deflationary which provides one of the pillars of support for the current Zero Interest Rate Policy (ZIRP) and the commitment to keep rates low through 2014.

In thinking about 10-year rates, most people are of the view that they are artificially low. I am generally of that view. But I think it is important to consider the opposite of what seems obvious; to what extent are rates actually just about right? In pondering the situation I reread Irving Fisher the father debt deflation theory; looking at how much housing debt is still to be written down in the US and I am not so sure how many basis points are artificial. I posit this thought, all the models which suggest we should be at 3.0% rates on the 10-year don’t have a pending debt write-down of $1.3tn as one of their factors.Of course it is possible that forbearance suddenly begins to “work” but doubt the US government will be that patient.

As the father of debt-deflation theory, Irving Fisher, wisely observed “Disturbances in these two factors—debt and the purchasing power of the monetary unit—will set up serious disturbances in all, or nearly all, other economic variables. On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33.” In the case of the housing market, debt and deflation are most certainly present. With house prices falling between 25-33% from the peak depending on what index one uses and with debt reaching historic highs, Fisher’s perfect storm conditions exist. Housing had reached 6% of GDP in the past, but it never fell quite so far so fast because there was never before this much leverage in the housing market. That we are experiencing economic and interest rate market disruptions from the bursting of the housing bubble is not much in dispute either. That the debt overhang in the housing market still has the potential to be deflationary is widely debated inside the Fed and on trading desks around the globe.

In Fisher’s work on debt-deflation he cites nine factors which can work in a variety of combinations that perpetuate vicious circles. Contraction of deposit currency is one of the factors that the Fed’s QE has averted. Despite this, a reduction in output, trade and employment and loss of confidence, three other factors, was not averted. However, due to the Fed’s actions, the ninth and most pernicious factor (disturbances in the interest rate) has been mitigated substantially. While we have seen “complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest” real 10-year rates are negative at present despite having been quite elevated in 2009 (see graph above). In analyzing the data much of the deflation witnessed over the past five years has been in the real estate sector and while there is still a large debt overhang, the fall in prices appears to have nearly come to an end. The real question that remains now is whether the current debt overhang that remains in the real estate sector can be cleared quickly and how will the costs borne in this effort impact rates and the real economy. If we allow a continuation of forbearance this likely means a prolonged period of bouncing off the bottom on prices and a somewhat slower return to normal lending or price appreciation than if the books could be magically be cleared of the $1.3tn of underwater loans.

Turning to inflation, if we assume that Core CPI continues to rise between 0.15% and 0.20% on a month over month basis until the end of 2014 we will wind up with the chart above. Never before have policy rates been this much below Core CPI for so long. My first reaction to this graph is, “this is not something we have seen before”, but then very few of us were around between 1929-33 or 1873. The question about whether or not we get inflation centers in large part on what happens with the remaining $1.3tn of bad debt that has yet to be realized in connection with the housing bubble bursting. The measures taken so far to assist the housing market have been piecemeal however; they have made a dent in the problem. If substantial further dents can be made either by enabling (forcing) write-downs or by supporting demand with programs for increased lending, and REO to rent programs, then the debt overhang problem begins to go away and but in the near term, it puts deflationary forces into the mix. On the other hand (you didn’t think I was a one handed economist did you?) if we get some lift in housing which takes prices up even a modest 2-3% per year, we will still have a huge debt overhang, but we will also have more hope for the forbearance plan which in conjunction with other measures could see us back at a place where housing makes up 4% of GDP sometime after 2020. When looked at in this light, a 2014 target date seems a bit more reasonable.

So should rates be at 3.0% now? Probably not. Should they be at 2.0% and are they likely to fluctuate between 1.8 – 2.20% in the near term, it seems to me this is quite likely. We would need a substantial jump in employment (not out of the question) and a knock on effect in housing to think anything otherwise; at this point, the debt overhang is still just too large to be waved away by a few months of good data.

exactly right. The FICA exemption is at the wrong end of the pay and income scale. It makes a mockery of the claim that the tax system is progressive. This is especially true in the case of self employeed workers, whose ranks have never been larger.

I think that the economy will not return to "boom times" anytime soon, we really need to look at "haircuts" to bring housing values in line with debt loads, otherwise, we will continue in this ditch for a very long time. Agree?

Why on earth would we want house prices to rise? What exactly does the author expect higher house prices to do for the economy? The story of the housing bubble was the consumption spurred by what proved to be illusory housing wealth. Therefore, getting house prices up again is a rather perverse way to try to generate demand in the economy. Essentially higher house prices transfer claims to wealth from non-homeowners to homeowners. The higher house prices go, the more wealth homeowners can command and the harder it is for non-homeowners to become homeowners. (This is known as the "unaffordable housing" policy.) If we just want someone to spend money, wouldn't a tax cut for the middle class do the trick better? Or, as more long-term policy, how about boosting net exports?

I'm sure that when the next stock market crash occurs,all the people who bought on margin will be forced to sell,driving stocks lower and hurting everyone holding stocks.I guess the govt will forgive those margin debts so stocks don't fall,hurting everyone.We do live in a village.Just ask Hillary.

The ratios of debt and dollar production seem far greater than the relatively small amount of current and future deflation required away from the Housing market. Core CPI which has always amazed me at it's construction doesn't record any real deflation in the costs of life. Real Food costs is double going on triple in just five years. Fuel is double.

The percentage of investors and industry with investment capital has emulated GE, Goodrich, Cessna, Honeywell and others very recently in 2011, 2012 by building manufacturing plants and maintenance facilities in Mexico just three to six years after investing in and creating headquarters groups overseas for investment in Asia. There is little incentive for industry unless we get Government Union and Private Sector Union wage and pension Deflation. I see little investment coming back to America certain;y in manufacturing which is at historic lows. What we are talking about really is the need for dollar purchasing power increasing substantially for real goods. "Real Deflation". Do you see that?

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